Is debt a false indicator of Canada's economic vulnerability?

Fresh research from policy think tank hints at more accurate predictor of financial crises

Is debt a false indicator of Canada's economic vulnerability?

In a recent lecture at Laval University in Quebec City, Bank of Canada Deputy Governor Paul Beadry said that policy makers must consider rising debt levels in weighing decisions such as changing interest rates. But if a new paper from the C.D. Howe Institute is anything to go by, that focus is only partly on-target.

“Canada is often cited as having worryingly high household debt-to-GDP and debt-to-disposable-income ratios, but the assets and net worth of Canadian households have grown more quickly than their debt,” wrote co-authors Jeremy Kronick of the C.D. Howe Institute and Steve Ambler of Université du Québec à Montréal.

In the paper titled Predicting Financial Crises: The Search for the Most Telling Red Flag in the Economy, Kronick and Ambler argued that high levels of financial vulnerability indicated by traditional debt measures are not necessarily red flags. For example, while the Office of the Superintendent of Bankruptcy (OSB) recently reported an increase in consumer insolvencies, its data does not distinguish between defaults due to true insolvency and those caused by liquidity issues.

“With stable debt to net worth, and with two-thirds of Canadian households owning homes, it could be that the bulk of these consumer proposals are a result of illiquidity problems,” they said.

And while the BoC’s monetary policy is informed by a financial vulnerability barometer, it does not include the debt service burden — that is, the sum of principal and interest payments by households on their outstanding debts. With that in mind, Kronick and Ambler constructed a modified barometer of financial vulnerabilities that incorporates Canadian households’ debt service burden as a key component.

“The barometer does a good job of tracking major recessions as well as other periods of elevated financial stress,” they said, noting spikes that coincided with events such as the recession of the early ‘90s and financial crisis of 2007-2008. With a sample period that extended further into the past, the model was also able to pick up the recession in Canada in the early ‘80s as well as the 1987 stock market crash.

The two researchers noted that the modified barometer was particular useful in detecting financial vulnerability ahead of recessions. A sharp decline in the index after the Great Recession, they added, suggests that financial risks in Canada are currently quite low, as opposed to what the BoC’s financial vulnerability tracker indicates.

“By focusing on debt servicing rather than debt, the barometer appears to yield fewer false positives than the Bank of Canada’s barometer,” they said.

Rather than focusing on traditional credit-to-GDP measures, which “were always going to increase in a low interest rate environment,” Kronick and Ambler encouraged regulators to closely monitor the behaviour of debt servicing for a more accurate assessment of risks to the economy.


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